What Has To Go Right For Gamestop

To do a reasonable job of exploring Gamestop (NYSE:GME) from an investment perspective, I'd like to begin by exploring the company's historical (and current) value proposition - what it is good at, and what could put those competitive advantages at risk. I will then forward into the digital market, looking at gaming trends, Gamestop's positioning relative to those trends, and the likely competitive landscape a couple years down the line. To start with, I will make brief mention of what Gamestop's historical value proposition has been:

What it is: Gamestop's business model has been to have a multitude of very small, relatively low-cost locations scattered everywhere. Wherever you live, there's a fair chance that the closest video game seller is a Gamestop. Gamestop's physical competitors (generally big-box retailers like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT)) have a different business entirely - fewer, more spread-out but significantly larger and less specific product offering. However, the large size of Wal-Mart and Target stores essentially prohibits placing too many stores together in the same near vicinity. Gamestop has no such problem, can concentrate its smaller stores - and as a result, wherever you live there's a fair chance that a Gamestop is the closest videogame retailer to you. As a corollary, this wide profusion of locations makes it very difficult for any other similar competitor to operate. You can buy an item at a location next to a friend's place 45 minutes away - and then, if it doesn't work, you can return it to the Gamestop next to yours. It's hard for anyone else to compete with this value proposition, so Gamestop has had something of a natural monopoly in the dedicated game-retailing market. Back on the issue of proximity - if you're a hard-core gamer who has been waiting impatiently for a game, where are you going to pick it up on opening day? I'd hazard a guess that the answer is 'wherever's closest.' And fairly often, Gamestop fits the bill.

Secondly buying from a Gamestop is fast - you walk in, ask the employee behind the counter if they have 'title x.' They either do or don't, and you go on your merry way. You don't have to drive to your nearest Wal-Mart, spend ten minutes walking through the store, and then wait in line. If you know what you want, Gamestop is just much more convenient. Which brings me to what Gamestop is - the best place to buy a specific product if you already know what it is. It is also a convenient location for present-shopping for kids - a parent can walk in, ask the person behind the counter (who generally seems to be an experienced gamer) what's popular on a specific system, and get it for their kid. Convenient. Gamestop has had a reputation for actually having employees who are interested in games (unlike electronics department guys in Wal-Mart or Target). Based on the number of presents to kids handed out with Gamestop bags, it helps.

Thirdly, Gamestop sales have been buoyed by the company's competence in the used game market. Say you're an individual who has purchased a game and no longer plays it, but wants to buy a new game. Gamestop allows that individual to trade in the game for credit towards a newer purchase - increasing sales at Gamestop (relative to competitors who do not offer trade-in credit), and cheaply increasing Gamestop's inventory. Although the widespread adoption of internet sales has reduced the value proposition somewhat, Gamestop is able to maintain advantages relative to other physical sellers (and over internet sellers for any individual who wants a game 'now' rather than having to wait a week for it to arrive with cheap shipping).

So the primary value propositions from my perspective are omnipresence, transaction quickness (and game-specific focus), and trade-in credit which incentivizes customers to return to Gamestop. These factors have contributed greatly to Gamestop's past successes, creating a virtuous cycle allowing Gamestop to outcompete its competitors. However, it is important to note that all three of these advantages are specifically related to physical game sales; none of these necessarily provide any competitive advantage in the digital game arena. I think it's fairly intuitive to say that games are headed towards greater reliance on digital downloading (both of entire games and of downloadable content additions after the initial game purchase). See Sony's purchase of Gaikai or Steam. As a result, I don't think I'm going out on a limb here to say that Gamestop is transitioning from a physical-game business (in which it enjoyed multiple competitive advantages) into a more difficult and competitive digital gaming business.

However, before just assuming that such a trend is feasible in the near term, I had a few issues I thought through during my considerations - primarily with respect to how long it will take to download a game with current internet speeds, and the (increasing) size of newer games relative to increasing storage capacity.

Game Size: Games have become increasingly large and detailed. For example, the PC version of the Elder Scrolls V - Skyrim requires 6GB of free space to download online. At my actual wireless download speed (about 7.5mbps), this would take me about 1 hour and 45 minutes to download - it would be much faster to head over to Gamestop, buy a copy, and get back (courtesy of the 2 Gamestops located within 5 minutes' walking distance from my house - and about 30 seconds walking distance from each other). If I wanted to buy Diablo III, it would be approximately 3.5 hours (based on 12GB download size and internet speed tests). With download times like that, the only thing I could say with confidence is that it would be a game-by-game decision whether to go to Gamestop to make a purchase or wait for the download. As it is now, I buy the few new games I play at Gamestop (usually via preorder) - however, when console games shift towards greater download centricity, I will be purchasing fewer physical games and doing more downloading. So I believe this concern stands; sometimes it's more convenient just to do some placeholding activity for an hour or two rather than go somewhere…

Hard Drive Capacity: Hard Drive space increases should be adequate - even with increasing game sizes. While I have to compelling reason to speculate about the types of hard drives that will be used in future game platforms, internal 500GB hard drives are available for easily under $70/apiece at the retail level, with cost/GB rapidly declining. I'm not trying to even remotely get into guessing technical capabilities of newer systems - the point I'm making is that even 500GB holds over 80 Skyrims. Even downloading today's largest, most popular games, it would take time to fill up a 500GB hard drive. So my initial concern that game size growth was outpacing growth in storage capacity seems to lack substance.

Digital Sales and Business Transitions

The major driver of GME's used game sales historically has been something like this - somebody wants a game, purchases it at Gamestop, plays it, and then sells it back to Gamestop and uses the credits to fund part of a new game purchase. In this way, Gamestop makes money on multiple transactions, and ultimately recoups its inventory as well. This gives Gamestop a competitive advantage over other physical game sellers who will not accept trade-in credit (or who are less effective in selling used games that are traded in).

However, what I haven't seen mentioned much (though David Weinstein did in the comments on Matthew Dow's article) is that digital sales break this cycle: you can't resell your digital content back to Gamestop. Gamestop cannot provide a differentiated digital product proposition, so I believe a movement towards digital downloads would actually whittle away at Gamestop's competitive advantage in the physical product arena - a person who uses up all his/her built-up credits (and physical willing to be traded in) on digital content now has no compelling economic reason to go back to Gamestop rather than to a[n increasingly online] competitor.

And actually, I like Gamestop's digital revenues less than I like their physical counterparts.

A) Because, as already mentioned, physical revenues 'recycle' while digital revenues do not (barring an unexpected U.S. ruling like the EU's)

B) Because digital content in the form of selling credits for downloadable content has a weak competitive position - I have reviewed the arguments about why people buy DLC content from Gamestop (primarily involving the ease of the 'one-stop' shop vs. having to use various different DLC portals, and being able to begin DLC downloads to your XBOX before leaving the store) - and have found them to be pretty weak. DLC downloads - even using disparate portals - is very simple and intuitive, and - most importantly - easy to do. Even though I have 2 Gamestops within five minutes, it would be faster and more efficient to download multiple DLCs directly (and this is indeed what my gamer friends do). So the convenience factor will not draw customers into stores; it is simply add-on revenue (albeit high-margin add-on revenue) for customers already in-store for some other reason. And for the 'immediately starting the DLC downloads' issue - again, the problem over the intermediate/long-term is that it requires the purchaser to be in the store to enjoy the 'convenience factor'; as the industry shifts towards digital downloading/streaming and away from physical purchases, the customer is less likely to be physically in the store - and more likely to be downloading from home. Thus, ironically, this type of digital download is highly correlated with physical sales - as sales of physical disks decline, so will this type of digital revenue.

C) Because increased downloading of online games - whether from Gamestop or anybody else - will cause an accelerated decline in the used game market. Fewer physical sales of new games equates to fewer physical used sales later. This also ties back into a) and will cause accelerated weakness in Gamestop's competitive advantages vs. other sellers.

D) It's hard to think Gamestop can parlay its physical presence into an online advantage over even the intermediate term. For physical games, I go to Gamestop because it's the closest location. Its omnipresence gives it a competitive advantage versus competitors farther away (who are generally larger companies that rely upon bigger-store formats, which prohibit packing locations as tightly together as Gamestop does). But no such advantage exists over internet-based sellers (even if Gamestop is allowed to compete - which given that console manufacturers will likely be the exclusive download intermediaries for their consoles may be an aggressive assumption on my part). There's no compelling reason for me to download a digitally-available game from Gamestop when it's available elsewhere (again unless digital resale is allowed a la the EU - however it is the EU plans to implement that ruling).

E) As discussed everywhere, game publishers themselves are incentivized to cut Gamestop out. If a game can be sold digitally, then the game publisher (or distributor) can sell it digitally itself and improve margins. Even if game publishers do opt to use third-party downloading infrastructure, who's to say which companies are going to be successful in the space…it is far too early to make any predictions here. And, unfortunately, I think this is quite a vital prediction one needs to make in order to determine the future path of Gamestop's business…

Basically - and I don't think I'm going out on a limb here - Gamestop is in a transition phase from an excellent business with a competitive advantage into a difficult business with low barriers to entry and various parties that are incentivized to cut them out of the loop. And, ironically, the further Gamestop pushes into the digital realm, the faster it erodes the competitive advantages that have buoyed up its brick-and-mortar sales. This is not a statement that I think will generate much disagreement - however, I think its importance is generally understated. Firstly, I think people tend to misunderstand what 'digital revenue' really is - 'digital' seems to be widely considered some type of revenue that will outlive the obsolescence of the game disk - and in Gamestop's case, this is not necessarily true. As I demonstrated earlier, download credits are highly correlated with physical game sales, and will thrive or fall in like fashion. Secondly, just because Gamestop enters into the digital arena and attempts to sell game downloads does not mean that they will succeed:

a) because console manufacturers will use their own download systems in their consoles (and try to cut Gamestop out of digital downloads for console games).

b) because content owners should have greater pricing power in a digital marketplace. Because there are few barriers to entry in terms of setting up an online download portal (aside from plunking down a sufficiently large pile of cash), any excess profits are going to be competed out of the system. Even if Gamestop successfully achieves a high share in PC game downloading revenues, it will occur at commoditized margins.

c) Gamestop will likely compete against players who can afford to subsidize their services. A worst case scenario in the digital download or streaming business for PCs would be having to compete against Amazon (NASDAQ:AMZN) or a similar player; I have not seen this possibility mentioned before, but who thinks that the digital download or game streaming market would not be a good fit given Amazon's competencies?

To be long Gamestop for anything other than a short-term trade, I think you have to be confident in most of the following:

1) That the decline in physical gaming will be a gradual enough process, or occur far enough down the line, that Gamestop will have generated substantially more cash flow than its current market cap from this business.

2) That Gamestop will obtain and retain a highly profitable position in digital revenues, despite the incentives from console manufacturers to cut them out of the loop in the console gaming market, and despite the likely appearance of well-funded, low-cost players willing to subsidize the service until critical mass is reached.

3) That share buybacks actually provide value for shareholders - which also goes back to #2 - after all, if management buys back a huge number of shares but Gamestop has no meaningful residual business by the time its legacy business starts really taking hits, then that is essentially wasted cash flow (that could have been returned to shareholders in other ways). In my opinion this is the biggest element of the Gamestop short thesis - an unfortunate cash return policy.

4) That Gamestop management will be able to manage its lease obligations successfully enough to avoid a solvency crisis if/when the physical disk sales begin falling. Per the 2012 10-k, Gamestop typically leases locations under 3-7 year lease terms (with extension options), and leases all of its 6500+ locations. This kind of refers back to #1 and interrelates with the point - this will be easy to do (relatively speaking) if the fall-off in the physical disk business is very gradual - and very difficult to do if technological advances make the transition occur over a relatively short time period.

Noticeably absent from my discussion here so far - any discussion of valuation. I'm not going to go into enormous detail here, as others have already (back to Matthew Dow's article again). Suffice to say, valuation relative to a company with stable outlook is exceptionally cheap. However, I feel compelled to again point out GME's prodigious stock-buyback activities - see the first page of GME's Q3 2012 earnings transcript for details, but suffice to say that over $1B has been bought back since 2010, for a company with a ~$3.1B market cap.

So, for the next logical step in the analysis: What could go wrong with a short position (I mean ignoring omnipresent issues like potential for ballooning borrow costs, especially in the face of high buybacks, and short-squeezes)?

There's one very significant possibility - Better capital allocation. In my opinion, the single largest detractor from Gamestop is the capital allocation policy (specifically, the policy of buying back huge numbers of shares). Share buybacks are only accretive to shareholders in businesses that are undervalued and are likely to continue to exist long into the future. If Gamestop switched from a policy of heavy buybacks to a 100% dividend policy, a large portion of the short thesis would be fundamentally busted (it doesn't take many years for a company trading at a double-digit cash flow yield to pay out high percentages of its market cap in cash, leaving short sellers with mediocre IRRs over multi-year time frames even if the remaining fundamental short thesis is correct). Shorts, right now, are getting a helping hand from misguided capital allocation policies.

I have to conclude that a long position in Gamestop right now is a multi-part bet: that high-margin used game sales remain robust over the medium term, that Gamestop will be able to obtain and retain a significant share of digital downloading revenues (and do so at high margins despite streaming markets being the domain of competitors with larger pockets), that it will be able to wind down its physical operations without undue financial strain, as well as requiring confidence that share buybacks are not destroying value (or if they are that capital allocation policies will be reconsidered promptly). This is a fairly serious set of compounding positive assumptions, any one of which has the potential to botch a long thesis by itself.

As always, do your own research and form your own opinions (although I hope my article has made the process easier for you). Comments - especially alternative views - are appreciated.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in GME over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author holds a small short position in Amazon